Price update clause or how traders could protect themselves from drastic changes in market conditions
Nov 2, 2021News & Analysis
“The builders shall cease the sales of property before it is finished”, “Due to the rising prices, advanced sales of property ceases”, “Shock for the property market! Advanced deals cease” – These and other similar titles abound in media space over the past few months. The reason for them is related to the drastic rise in prices of construction materials, energy sources and the already erupting high inflation wave, due to which a large part of the construction business in our country, although it continues to build, suspends the conclusion of preliminary sales agreements, while the construction process has not yet reached a stage that allows builders to assess the cost of properties and their market prices.
Without underestimating the seriousness of the current economic situation in our country and internationally, such media noise and sharp turns in the business behavior of the construction industry are exaggerated, as the law has long provided mechanisms for dealing with such situations of economic uncertainty. Due to the constantly rising levels of the prices of raw materials, labor or goods and services in general, the business is exposed to a serious risk when concluding long-term contracts. What shall a trader do when he does not want to miss a reliable customer now for his future product or service, but is unsure about how much it will actually cost him to provide this product / service in the future?
The answer is simple – by providing in the customer contracts of the so-called price determination clause, also called a price update clause or a price indexation clause. Behind this terminology is in fact the possibility provided by law for concluding a contract at a not initially determined final price, but at a determinable price. However, in order to comply with the requirements of fairness, predictability and transparency of contractual relations, price determination should not be made subject to subjective criteria, but should be based on objective external factors, which can reasonably be perceived as measures of changes in economic and economic life and can therefore be relied on for a fair distribution between the trader and the customer of the risks of unforeseen market fluctuations.
There are cases known in practice in which the price determination clauses in the contracts consist of very laconic formulations of the type “the price set in the contract changes accordingly to the change of the market index…“. Indeed, price determination clauses most often link the contract price to changes in a particular market index, but betting on this condition in the contract in such a blanket way carries serious risks of future disputes with an unclear outcome. The introduction of contractual clauses for price indexation / updating is a responsible task, the implementation of which should take into account a number of specifics. Here are some of them:
QUICK GUIDE FOR WRITING A PRICE INDEXATION / UPDATE CLAUSE
(1) Set a base price to be updated.
The price per unit of product / service to be updated should be fixed as accurately as possible. Specify whether the specified base price refers to a unit of product or a specific quantity of output. Set the specific month and year for which the base price is set; this time point is often called the base time point. In case of an appropriate arrangement, set a period of time during which the base price will remain unchanged.
(2) Select the appropriate index or indexes.
These are economic business indicators maintained by trustworthy bodies and institutions, aiming to objectively measure changes in price levels and the business climate over time. This information, in turn, can be used to update the base price originally provided for in the contract, so that in the future the trader can maintain his originally envisaged profit margin and not be forced to enter into expensive and uncertain cases of economic intolerance. contract. In the specific example with the construction industry, such an appropriate index would be the official CCI index maintained by Eurostat (EU Statistical Office) for trends in the price of new construction.
(3) Clearly indicate the selected index and cite a reliable source of information about it.
The contract price update clause should individualize the selected index or group of indices, providing information on its exact name and identification code. The clause should also refer to a specific official or other source of up-to-date index data.
(4) Specify whether indices with or without seasonal adjustments will be applied.
In general, seasonally adjusted indices are not suitable for a price update clause. As this clause is usually intended to capture real price changes, the contracting parties would in most cases not want the seasonal specifics of price changes to be eliminated for the purposes of their contract price calculations.
(5) Specify the frequency of price updates.
The price update clause should clarify how often the price will be updated – quarterly, semi-annually, once a year or any other period. The price update should be calculated at certain time intervals, and the base time under the contract should be used for their beginning. As it became clear above, this is the time associated with the agreed base price. Problems could arise with contracts that do not provide for a certain frequency of price updates. The following paragraph and guideline (7) provide more details in this regard.
(6) Provide procedures in case of missing information or cessation of keeping the selected index.
It is not an exception in cases where the statistical information from the selected index is not available, most often due to the fact that the initial information on price levels has not been provided to the statistical authority / institution by a significant number of respondents. Highly detailed indices are more susceptible to such a problem than indexes with a higher level of generality. For such cases, the price update clause should provide for procedures to obtain the missing information from the selected index. Sometimes it is possible to permanently suspend the maintenance of an index if, for example, a product suddenly loses its market value. The situation is similar when an index does not meet the minimum standards for publication, where the contractual clause for price determination should provide guidelines for substitute indices in case of cessation of the maintenance of the initially selected index. If the index-maintaining institution makes a change in the name or code of the relevant index, it will essentially remain the same index, so such a situation should not necessitate renegotiation of the established price update clause.
(7) Please note that for the price indexation the most up-to-date version of the information from the index to the moment of calculation of the price indexation agreed in the contract should always be used.
This rule requires the contracting parties to explicitly specify the base time and subsequent months of the index that will be used to calculate the price, as well as the exact time at which the calculation will be performed to establish the update. Following this rule can save many future problems. Contracts that do not provide for such arrangements should specify which version of the index information should be used for the purposes of the calculations, as:
(a) some indexes update the information in them for a certain period of time after their initial publication;
(b) sometimes these periods of time change; and
(c) although in rare cases the information of an index may be subject to adjustment.
For effective compliance with guideline (7), it is important not only to determine the frequency / intervals of the price update, but also the indicative date on which the update will take place.
The choice of the contracting parties on the date for the price update should be made only after they have agreed in advance on: (a) the month of the base time, (b) the time interval for the price update, and (c) whether the calculation will be based of the originally published or final index values for the month selected for comparison in the price indexation. It is extremely important that these issues are clarified before signing the contract. Otherwise, disputes could arise if the initially published index information and its final values differ.
If the parties do not specify the specific date for the price update, the contract should at least provide for whether the initially published index information or its final values will be used for the purposes of the calculations. If possible, it is preferable to use the final values of the index information, because only the final values will be replaced by retroactive action when changing the initial base values of the index by the institution supporting it.
The contract should not refer to index values relative to the base price, but rather to the index values for the respective month and year. For example, the following referrals could create problems in the future:
“Divide the current index value by 103.9 (this is the base time index January 2010) and then…”
Such an arrangement should be worded as follows:
“Divide the index value that corresponds to the month of the January 2010 price update, which represents the index value at the base time and beyond ….”
(8) Do not link the indices used for the purposes of the price update with a specific initial period on which the index is based, as this initial period may be changed by the institution maintaining the index.
(9) Define the price update methods.
(a) Simple percentage method.
In this method of price update, the base price changes by the same percentage as the corresponding index changes. Let’s illustrate this with a concrete example – let’s assume that the price update clause provides for the index “X”, without seasonal adjustments, and that its value for December 2010 was 178.4 and this is the base month to which the base price the contract is set at 1000 euros per piece of production. Twelve months later, when the index information for December 2011 was published and when the first price update was to be calculated, the index value for December 2011, published in mid-January 2012, was 187.7. The percentage change shows an increase of 5.2 percent in the index values and a corresponding increase of 52 euros in the base price per unit of output.
(b) Update of part of the price.
This method allows only part of the base price to be updated according to the selected index, while the rest of the price remains fixed.
(c) Composite indices.
Some contracts provide for the construction of a composite index based on different indices. The advantages of the composite index are that it can more accurately identify the appropriate price change of the base price, as it refers not to one but to several of the costs associated with the production / provision of the product / service. However, the composite index assumes more calculations at the time of the update than the simpler methods described above. Although composite indices are based on official index values, they themselves are not official indices.
(d) Limit price update.
Price update clauses sometimes include a lower or upper threshold, or both, in order to set price indexation limits for the duration of the contract. Sometimes, however, contracts stipulate that the updated price cannot fall below the base price, ie there can only be an upward movement. It is also possible to stipulate that the price update should be activated only above certain levels of change of the reference index values.